Short-selling a stock, known commonly as “shorting stocks” or just “short stock”, is the opposite of buying a stock or shares in a company. When an investor short-sells a stock, they borrow shares from their broker’s account or their broker borrows shares from another investor, and then the short stock seller sells the shares with the expectation the stock price will decline, at which point the shares will be bought back. Essentially, the investor is selling shares they do not own with the intention of buying them back at a lower price and keeping the difference between the sale and purchase price.
This process creates a different risk profile than buying (i.e. being long) a stock. In the case of being long a stock, the maximum risk is 100% of the investment, in the case the stock goes to zero. However, the maximum return is theoretically unlimited, as in theory, a stock price can trade to infinity. With shorting stock this risk profile is reversed, where the maximum gain is potentially 100% of the investment, if the stock were to drop to zero, and the maximum risk is unlimited (should the price rise to the theoretical level of infinity). For this reason being short a stock is a higher risk position than being long, and adequate risk management techniques should be incorporated, such as employing a stop loss order (an order to sell a stock should it rise above or drop below a specified price) to avoid large losses.
Another risk an investor needs to heed when short a stock is that if that corporation pays a dividend, the participant who is stock shorting must pay the investor who lent the stock the dividend. This means the investor short a stock can lose money even if the price of the stock is unchanged.
A final common risk is that your short position could be called away before you are able to make a decent return. If the lender of the shares decides to put those shares up for sale, the investor who is short the stock must return the shares to the lender regardless of price. This requires purchasing the stock in the open market. Often when a stock begins to decline or is overpriced, the gain is limited due to the original owner wanting to sell the shares. If the investor who is short wants to continue to be short, they would have to find another investor willing to lend the shares and this may create multiple transactions to complete a single short trade objective.
Even with the inherent risks, investors still choose to short stocks and one of the reasons is that a stock is very overvalued or is a fraud, so its value is artificial and the investor is certain it will decline due to these reasons.
A second reason is to hedge risk. In this case an investor could be long one sector they feel is undervalued and short an overvalued sector (or long a lower risk sector and short a higher risk sector). This type of trade may make sense should an investor believe the stock market in general is going to decline, and would be less risky than being short outright.
A third reason an investor may want to be short a stock is for a paired trade. A paired trade consists of being long an undervalued stock and short an overvalued stock. It could be in the same sector – (e.g. long bank A and short bank B) or across sectors (e.g. long energy and short airlines). This paired trade lowers the risk of being outright short of a stock.
One may wonder why a stock exchange would allow investors to be able to profit from stocks declining. Essentially it comes down to two reasons, the first is liquidity. When markets are declining an investor who is short eventually needs to cover his short and buy the shares back. This provides buyers in downtrends and often leads to either intermediate or long term bottoms, when a majority of those short decide to cover.
The second reason is that short stock sellers have been very good at determining frauds. It was a short-seller who uncovered the frauds at Enron and WorldCom (to name just two). A rising short interest in a stock may give other investors a reason to investigate the financial statements of a company in greater detail and by doing so, alert investors of companies that are not being honest about the true state of their businesses.
There are slight regulatory differences for shorting stock in Canada vs. the USA. Between 1937 and 2007, in both Canada and the USA an investor could only short a stock when its last trade was up, the Uptick Rule, however, the US removed that rule in 2007 only to reinstate it in 2015 for certain stocks, under specific conditions. For more detail on the changes in regulations, one should consult with their advisor on the current regulations governing shorting stocks in Canada and the US.